ARCHTesttutorial 1 SpiderFinancialCorp,2012

TheARCHEffectExplained
Intimeseriesandeconometricanalysis,summarystatisticsandresidualdiagnosisoftenleadustousea
somewhatmystifyingtestknownastheAutoRegressiveConditionalHeteroskedacity(ARCH)effecttest,
orARCHtestforshort.WhyexactlydoweusetheARCHtest?

YoumightthinkofofanARCHtestsimplyasameansofdetectingforthepresenceoffattailsinthe
underlyingdistribution;butifthatweretrue,whatwouldthetesttellusthatatestforexcesskurtosis
couldnot?
WeneedtoanswersomebasicquestionsabouttheARCHtest:Whatdoesitdo?Howisitrelatedtothe
whitenoisetest?Whenshouldweutilizewhatithastotellus?
Note:Forillustration,weareusingtheIBMstockpricesdatasetfortheperiodbetweenMay17
th
1961
andNov2
nd
1962(SeriesBinBox,JenkinsandReinsellTimeseriesforecasttextbook(1976)).
Background
Letsassumewehaveadatasetofaunivariate{ }
t
x ,andwewishtodeterminewhetheritexhibitsan
ARCHeffect.
1. Constructanewtimeseries
t
y ,suchthat:

2
t t
y x =
2. Formaportmanteautypeoftestfor
t
y :

1 2
1
: ... 0
: 0
o m
k
H
H

= = = =
- =

ARCHTesttutorial 2 SpiderFinancialCorp,2012

Where
o
H =nullhypothesis
1
H =alternativehypothesis(autocorrelationissignificant)
m=maximumnumberoflagsincludedinthetest
i
=thepopulationautocorrelationfunctionofthesquaredtimeseries(
t
y )
1 k m s s
Inessence,theARCHeffecttestisawhitenoisetest,butforthesquaredtimeseries.Inotherwords,we
areinvestigatingahigherorder(nonlinear)ofautocorrelation.Howcanthisinformationbeuseful?
TheARCHeffecthasitsrootsintimevaryingconditionalvolatility,so:

2 2 2 2
( )
t t t t t
E x x E x x o ( ( = =


Where
2
t
o =conditionalvariance
t
x =conditionalmean
Assumingthetimeseriesdoesnothaveasignificantmean(typicalinfinancialtimeseries),thenthe
conditionalvarianceisexpressedas:

| |
2 2 2 2
( )
t t t t t t
E x x E x E y x o ( ( = = = ~


Assumingthesquaredtimeseries(
t
y )isseriallycorrelated,thenconditionalvolatility(
t
o )variesover
timeandexhibitsaclusteringphenomenon(e.g.periodsofswingsfollowedbyperiodsofrelativecalm).
Insum,theARCHtesthelpsustodetectatimevaryingphenomenonintheconditionalvolatility,and
thussuggestsdifferenttypesofmodels(e.g.ARCH/GARCH)tocapturethesedynamics.
WhitenoisetestconditionalmeanARMA/ARIMA
ARCHtestconditionalvolatilityARCH/GARCH
Q:Canwehaveasignificantserialcorrelationintheoriginaltimeseriesandaserialcorrelationinthe
squaredtimeseries?Ifso,howcanwemodelthat?A:Yes;weuseanARMAGARCHmixturemodel.

ARCHTesttutorial 3 SpiderFinancialCorp,2012

Analysis
Letstakeacloselookatthelogarithmicdailyreturnstimeseries:

Thedailyreturnplotsuggestsastationaryprocesswithzeromean,butthevolatilityexhibitsperiodsof
relativecalmfollowedbyswings(akavolatilityclustering).
Thewhitenoisetestidentifiesinsignificantserialcorrelationinthetimeseries,buttheARCHeffectis
significantandindicativeofatimevaryingvolatility.
1. DailyReturnsDistribution
Letsconstructtheempiricaldistributionofthesampletimeseries,andexaminethetailsincomparison
withthoseofaGaussiandistribution.

ARCHTesttutorial 4 SpiderFinancialCorp,2012

ARCHTesttutorial 5 SpiderFinancialCorp,2012

TheQQPlotshowsanasymmetricalviewofthedistributiontails;thedistributionslefttail(i.e.
extremenegativereturns)arefarmoredeviantfromwhattheGaussiandistributionsuggests.Thisisa
welldocumentedphenomenoninthefinancialtimeseries.
2. CorrelogramAnalysis
Bynow,weveestablishedthatthelogarithmicdailyreturnsdistributionhasfattails(andmaybefatter
ontheleftsidethanontheright),butwhereisthetimevaryingclaimcomingfrom?
Inthedescriptivestatisticstable,theARCHeffectsuggestsasignificantserialcorrelationinthesquared
timeseries.Letsdothefollowing:
1. Constructthesquaredtimeseries(
t
y ).

2. RunNumXLdescriptivestatisticwizard,andgeneratethesummarytable.Thewhitenoisetest
onthesquaredtimeseriesisequivalenttotheARCHtestontheoriginaltimeseries.

Notice:theARCHeffectforthesquaredtimeseriesissignificant,sodoesthismeanwehavea
timevaryingkurtosis(fourthmoment)?Letskeepthisquestioninmind,andrevisititina
separatetutorial!

ARCHTesttutorial 6 SpiderFinancialCorp,2012

3. UsingNumXLCorrelogramwizard,generatetheACF/PACFtableandplotforthesquaredtime
series.

TheACF/PACFPlotforthesquaredtimeseriesisshownbelow:

ARCHTesttutorial 7 SpiderFinancialCorp,2012

3. ARCHModeling
UsingtheACF/PACFtables/plot,wecanproceedtomodeltheconditionalvolatilityasanARMAmodel
(akaGARCH).AsinARMA,weneedtoidentifytheARandMAorderoftheconditionalvolatilitymodel.
Conclusion
TheARCHtestisavitaltoolforexaminingthetimedynamicsofthesecondmoments(i.e.conditional
variance).Thepresenceofasignificantexcesskurtosisisnotindicativeofatimevaryingvolatility,but
thereverseistrue:asignificantARCHeffectidentifiesatimevaryingconditionalvolatility,volatility
clustering(ormeanreversion),and,asaresult,thepresenceofafattaileddistribution(i.e.excess
kurtosis>0).
Thecorrelogram(i.e.ACF/PACFanalysis)canbeusedtoidentifytheorderoftheAR&MAcomponents
intheGARCHtypemodel.
Finally,noticethatforfinancialtimeseries,thenegativereturnsdeviatemorefromnormalitythan
positiveones.